Sticking with strength

Commentary: Applying the Relative Strength strategy to ETFs

By

RobertW. Colby

NEW YORK (TradingEducation) -- There are some 227 exchange-traded funds from which to choose, tailored to just about every taste and style. So how should an investor decide which ETF to pick and when to execute the trade?

Over the very long term, covering multiple decades and including several major bull/bear cycles, no stock selection strategy beats Relative Strength (RS). This strategy is easy to understand: Buy and hold only the strongest stocks. When a stock slips enough so that it is no longer among the strongest, sell it and replace with whatever is the new strongest.

The RS strategy has been successful for a very long time. Samuel Eisenstadt, Research Chairman of Value Line Investment Survey, found that the top-ranked stocks by RS beat the Standard & Poor's 500 Index by 4.5 to 1 over a 15-year test period. RS is an important component of Eisenstadt's Value Line Ranking System.

In another independent study, Charles D. Kirkpatrick II, CMT, found that the top-ranked RS stocks outperformed the indexes by 4.7 to 1 over a 17-year period. Many other studies have arrived at the same conclusion.

Applying RS to ETFs

ETFs may be attractive for the average non-professional investor because they are as easy to buy and sell as a listed stock and provide a very broad array of choices, from foreign country funds, to sectors and industry groups, to styles (growth to value), to size of component stocks (large-cap to small-cap), and even commodities (oil, gold, silver).

ETFs hold baskets of stocks, so they provide greater diversification than any individual company stock. ETFs also offer lower operating expenses than most mutual funds. My daily and weekly rankings of 227 ETFs give me a useful perspective on the biggest, most important trends in financial markets around the world.

Simulated Cumulative Performance

21 months: Aug. 6, 2004-May 19, 2006

Source: TradingEducation.com, robertwcolby.com

Hypothetical or simulated trading does not include transaction costs, market impact and taxes. Simulated past performance is not indicative of actual or future performance.

My ranking period started Aug. 6, 2004, with only 120 ETFs. I added new ones as they became available and now rank these 227 ETFs at the end of every week according to the RS of their major trends. In simulated performance since August 2004, the 10 strongest ETFs performed 3.3 times better than the unmanaged S&P 500 Index
SPX, -0.23%
While the S&P 500 rose nearly 19%, the top 10 ETFs rose more than 62%, or about 43 percentage points more than the S&P 500.

Why just the top 10?

The RS strategy also worked well with the top 20 and top 30 ETFs, but my testing showed it worked best when concentrating on the top 10. Some ETFs can stay in the top 10 for weeks or months, but we cannot count on many long-term capital gains holdings for a year or more.

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